The purpose of estate tax planning is to maximize the assets you pass on to future generations by minimizing gift and estate taxes. Estate-tax strategies revolve around the use of irrevocable trusts. This article discusses the most common types of irrevocable trusts that are used to minimize gift and estate […]
A non-grantor trust is a powerful tax-planning tool. Millions of Americans have one (or more) of these trusts. But you may have never heard of them. Or you may be wondering what exactly they do. In this article, we provide background on trusts in general, what non-grantor trusts are, and why some people — particularly people with relatively high incomes and/or net worths — can benefit from them.
A trust is a legal arrangement in which one person (the grantor) transfers property to a person or entity (the trustee), who controls that property for the benefit of another person (the beneficiary). For income-tax purposes, there are two main types of trusts: grantor trusts and non-grantor trusts. A non-grantor trust is a particular type of trust that is treated as a separate taxpayer for income tax purposes. This sets it apart from grantor trusts, which are ignored for income-tax purposes, just like single-member LLCs. Non-grantor trusts file taxes and report income themselves. Whether a trust is a grantor trust or a non-grantor trust is based on the specific terms and provisions in the agreement creating the trust. (Here is a deep dive comparing both structures).
Non-grantor trusts are subject to a special form of income taxation. Here’s the basic idea: Each trust is taxed on the income it retains. In general, when a non-grantor trust makes distributions to the trust’s beneficiaries, it gets a corresponding deduction against its realized income. The beneficiaries then get a K-1 from the trust (like they would if they had income from an investment), and they pay any tax associated with that distribution. If the trust distributes an amount equal to its income-tax liability or greater, the trust won’t owe any tax on that income. Instead, the beneficiaries will pick up the tab. If the trust distributes an amount that is less than its total taxable income during that year, then the beneficiaries will pay tax on the amount distributed and the trust will pay tax on the trust’s remaining income. If the trust doesn’t make a distribution in a given year, the trust will pay all the taxes on the realized income and the beneficiaries won’t get K-1’s. This way, there is never double taxation; it’s just a question of whether the income tax is paid at the trust level or at the individual beneficiary level.
For example, let’s say Bob sets up a trust for his daughter, Susie. In 2024, the trust generates $200,000 of interest income. Of that amount, $130,000 is distributed to Susie individually. Susie receives a K-1 reflecting $130,000 of income; she pays tax on that income. The trust pays tax on the $70,000 that isn’t distributed to Susie. Note that if Susie is in a low tax bracket, she might not owe very much tax on that $130,000. There’s a good chance she’s in a lower tax bracket than Bob.
This two-tiered system applies with respect to most forms of trust income — including dividends, rental income, and interest income. It may or may not apply with respect to capital gains income, depending on the language in the trust agreement and certain elections made by the trustee.
About half the states either don’t have an income tax or don’t apply their income tax to non-grantor trusts provided that certain conditions are met. People in high-tax states are often drawn to these trusts because it’s possible to set them up in states that do not tax trust income and as a result avoid state income taxes on assets owned by the trust. It’s almost like an alternative to moving to Florida! Over time, people in high-tax states can save a ton in state income tax by shifting some of their asset-based income to non-grantor trusts.
It’s important to understand that income from assets in a high-tax state, like rental income from California commercial real estate, is going to be taxed by that high-tax state no matter what. But income that is not intrinsically tied to a particular state, like most dividend or interest income, is not subject to state income tax when earned by a non-grantor trust that is a resident of a no-income-tax state like South Dakota. Likewise, a Californian could set up a non-grantor trust in South Dakota, move a Nevada commercial property into it, and avoid having to pay California income tax on the rental income, since the rental income is sourced to Nevada, not California.
That said, the income-tax savings is somewhat dependent on where the beneficiaries live. If the beneficiaries live in high-tax states, they’ll pay state income tax on the distributions. From a state-income-tax perspective, a non-grantor trust will make the most sense for someone who is not planning to make distributions to beneficiaries in high-tax states in the near future — either because the beneficiaries are in low-tax states, or because the grantor wants to reinvest the proceeds inside of the trust.
Non-grantor trusts have their own federal tax brackets. They’re taxed at the exact same rates as individuals, but in an effort to prevent high-income people from setting up dozens of trusts and shifting a portion of their income into each trust, Congress compressed the brackets. In simple terms, this means that trusts reach the top tax bracket at lower income levels than individuals. For example, in 2024, a non-grantor trust hits the top federal tax rate of 37% after just $15,200 of income. But an individual single person doesn’t hit that 37% rate until they have over $609,350 of income! A married couple filing jointly doesn’t pay 37% until over $731,200 of income.
That said, often the high-income taxpayers setting up non-grantor trusts are already in the highest federal tax bracket, so the fact that the trust they’re setting up are also in the highest tax bracket doesn’t make a difference: They’d be paying the same 37% tax rate regardless.
Also, recall that these trusts are only taxed on the income they generate and retain. If they generate income but then distribute that income to beneficiaries in the same tax year, the beneficiaries (who may be in low tax brackets) will receive K-1s and pay tax on that income in lieu of the trust paying tax. If a trust isn’t paying income taxes because it distributes its income, its tax bracket doesn’t matter.
There are a number of reasons why these structures are popular, and many center around the tax savings they generate. Here are some of the big tax benefits of non-grantor trusts:
There are two other major non-tax benefits of irrevocable trusts. These benefits apply to both grantor and non-grantor trusts:
Non-grantor trusts have enormous tax and non-tax benefits. But they also have certain drawbacks and limitations:
Need some help to understand if a Non-Grantor Trust is the right fit for you?
Non-grantor trusts are a tool often used by high-net-worth individuals and families to minimize income and estate taxes, maintain privacy, protect assets, and provide structure for passing on wealth to the next generation. Below are some case studies that can help you understand how people incorporate non-grantor trusts into their tax plans:
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